Behavioral Finance - A Study of Investor's Emotion

By

Ms. Shradhanjali Panda

Lecturer (Finance)
Global Institute of Management
Hanspala, Bhubaneswar-752101

Abstract

Though Investment is a science deals with the study of capital market and then plan accordingly yet the
study of investor's emotion has a major role to play with. It is not sufficient to analyze Efficient Market
Hypothesis and its drawbacks rather one has to go for a behavioral explanation of investor's irrationality
a consistent and correlated manner. Thus comes Behavioral Finance, the study of the influence of
psychology on the behavior of financial practitioners and the subsequent effect on market, into existenc
In this study I have tried to analyze the concept of behavioral finance along with its four theories to
explain the behavioral aspect of investors. This paper also focuses on its limitations.

INTRODUCTION:

If we always assume that financial markets are efficient and investors are rational then why there are so
many studies about investor's psychology? Investment managers always want to make money for
themselves and for their clients. That is the reason they care about the "psychology" factor of financial
market as well as investors.

The behavior of investors is not always rational, so investment managers do not forget how the
psychology factor of a person plays a substantial role in behavior of financial market.

But, modern finance theories have almost completely ignored the role of the complex motivational and
cognitive factors that influence investor's (the best asset of a company) decision making.

In today's buyer-market, we should face the truth that psychology systematically explores human
judgment behavior and well being. It can teach us important facts about how humans differ from
traditional economic assumption.

LITERATURE SURVEY

Earlier economics was closely attached to psychology, which was amply displayed in the book "The Crow
A study of the popular Mind" published in 1896

by Gustave le Ban. The book was one of the greatest and most influential books of social psychology ev
written.

But with the development of Neo-classical economics, it has been taught to us that –

1) People have rational preferences among outcomes that can be identified and associated with a value
2) Individuals maximize utility and times maximize profits and
3) People act independently on the basis of full and relevant information.

At that time, expected-utility and discounted-utility models began to gain wide acceptance generating
testable hypotheses about decision making under uncertainty and intertemporal consumption respective
By this time psychology had largely disappeared from economic and finance discussions.

A revolutionary paper in the development of the behavioral finance and economics was published in 197
Two famous psychologists Kahneman and Iversky published their paper "Prospect theory - An Analysis o
Decision under Risk" and where cognitive psychological techniques were used to explain a number of
documented divergences of economic decision making from neo- classical theory.

In 1985, Wenner F.M. De Bondt and Richard Thaler published, "Does the Stock Market Over-react?" This
another milestone in linking psychology with Financial-Market and form the start of Behavioral Finance.
They discovered that people systematically over-react to unexpected and dramatic news events, results
substantial weak form inefficiencies in the stock market, which was both surprising and profound.

In 1981, Iversky and Kahneman introduced "framing". They showed that psychological principles that
govern the perception of decision problems and the evaluation of probabilities and outcomes produce
predictable shifts of preference when the same problem is framed in different ways.

Gradually a number of psychological effects and factors have been incorporated into behavioral finance
only to strengthen the subject.

DEFINITION:

This realization gave birth to Behavioral Finance, a study of the influence of Psychology on the behavi
of practitioner and the subsequent effect on markets. Behavioral Finance explains why and how markets
might be inefficient.

Thus, behavioral finance is a field of study that has evolved which attempts to better understand and
explain (through the use of psychology and other social sciences) how emotions and cognitive errors
influence investors and the decision-making process..

A STUDY / SCIENCE:

The key observations from the study of Behavioral Finance is that –

1) People often make decision based on approximate rule of thumb, not strictly rational analysis.

2) People do not appear to be consistent in how they treat economically equivalent choices if the choice
are presented in significantly different contents, which referred to framing- effect.

3) There are explanations for observed market outcomes that are contrary to national expectations and
market efficiency, which include mispricing, non-rational decision-making and return anomalies.

From the above observations it is clear that judgments can be systematically wrong in various ways.
Systematic errors of judgment are called biases. Financial decisions are made in situations of high
complexity and high uncertainty that preclude reliance on fixed rules and compel the decision-maker to
rely on intuition.
Following situations will clear the theme more clearly.

SITUATION-1:

Let us take two identical examples. In first example you are walking to a play carrying a ticket that cost
Rs.100/-. On reaching the theatre you discover that you have lost the ticket.

Would you pay another Rs.100 for a new ticket? Now suppose you are planning to buy the ticket at the
door. On arriving you find that you have lost Rs.100 on the way.

Would you still buy the ticket?

Though both the examples appear identical from economic point of view yet people appear to "frame" th
choice differently.

Interestingly most people would buy a ticket in the second case but not in the first, which shows that th
treat the loss of cash differently from the loss of a ticket.

SITUATION-2 (i):

Choose between

a) A sure gain of Rs.2000

b) 25% chance to gain Rs.10, 00 and 75% chance to gain nothing

Now choose between

SITUATION-2 (ii):

a) A sure loss of Rs.7, 500

b) 75% chance to loss Rs.10, 000 and 25% chance to lose nothing

A large majority of people (even when they have been warned to avoid narrow framing) Choose A in
situation 2(i) and b in situation 2(ii).

In first situation the sure thing seems most attractive whereas in second situation the sure loss is
repellent and the chance to lose nothing induces a preference for taking risk.

It appears that people react differently to situations involving the prospects for large gains as opposed t
large losses. That is investors are assumed to choose a riskier investment even a less risky one, exists
only if the expected returns of the riskier investment is greater than that of the less risky investment.

Thus in a situation involving large expected losses, people do not seem to exhibit risk-averse behavior,
which is a framing effect.

People also seem to overestimate the probability of unlikely events occurring and to under- estimate the
probability of moderately likely events occurring. Popularity of lotteries best explains the statement.

So, all the above observations show the importance of cognitive psychology to study financial market.
Investment decisions have both emotional and financial consequences over time. There is potential for
worry and for pride, for elation and for regret and sometimes for guilt as no one likes to lose, but regret
makes losing hurt more.

A financially optimal decision (the one that a fully rational investor would make) is of little use to an
investor who cannot live comfortably with uncertainty.

THEORIES OF BEHAVIORAL FINANCE

There are four theories of behavioral finance. They are as follows

1- Prospect Theory
2- Regret Theory
3- Anchoring
4- Over-and-under reaction

PROSPECT THEORY

This theory says people respond differently to equivalent situations depending on

Whether it is presented in the context of a loss or a gain. Most investors are risk averse
when chasing gains but become risk lovers when trying to avoid a loss.

EXAMPLE

Mr. Gupta had started at 12.00 pm from his hotel room and on his way to airport gets blocked in a huge
traffic jam. The plane was scheduled to take off at 3.00 pm. When he had been delayed for two hours, h
decided to cancel his ticket, knowing that he cannot make it to the airport in time. The traffic finally got
moving around 5.00pm, so he decided to collect his refund from the airport. While he was proceeding to
the airport, he was feeling happy that he has saved money by canceling his ticket at the last moment an
was feeling proud of his decision. However, when he reached the airport at 5.45pm,the ground staff told
him that the plane has been delayed by three hours and will take off at 6.00pm.But, it is impossible for
him to board it as he cannot get a ticket anymore…

Mr. Gupta is now cursing himself for the decision he made, for which he was proud, an hour earlier.

REGRET THEORY

Regret theory is about people's emotional reaction to having made an error of judgment.

Investors may avoid selling stocks that have gone down in order to avoid the regret of having made a b
investment and the embarrassment of reporting the loss.

They may also find it easier to follow the crowd and buy a popular stock : if it subsequently goes down ,
can be rationalized as everyone else owned it.

EXAMPLE

Sales professionals typically attempt to capitalize on this behavior by offering an inferior option simply t
make the primary option appear more attract.
ANCHORING

Anchoring is a phenomenon in which in the absence of better information, investors assume current pric
are about right

People tend to give too much weight to recent experience, extrapolating recent trends that are often at
odds with long run average and probabilities

EXAMPLE

According to a survey by Wall Street journal, at the peak of the Japanese market, 14% of Japanese
investors expected a crash, but after it did crash, 32% expected a crash. Many believe, defying logic, th
when high percentage of participants becomes overly optimistic or pessimistic about the future it is a
signal that the opposite will occur.

OVER-AND-UNDER REACTION

"The market does not reflect the available information as the professor tells us. But just as the funhouse
mirrors don't always accurately reflect your weight, the markets do not always accurately reflect the
information. Usually they are too pessimistic when it's bad and too optimistic when it is good". Bill Miller

The consequences of investors putting too much weight on recent news at the expense of other data are
market over or under-reaction. People show overconfidence. They tend to become more optimistic when
the market goes up and more pessimistic when the market goes down. Hence, prices fall too much on b
news and rise too much on good news. And in certain circumstances, this can lead to extreme events.

EXAMPLE- Contemporary financial situation is the best example of this theory. In the month of May, 20
when Sensex was touching 22000 still investors were predicting that it will touch 25000 or 30000 withou
realizing it was the extreme situation. Investors were putting too much weight on current situation and
became optimistic.

CRITICISM TO B.F.:

Behind every successful thing, there is always criticism. Behavioral Approach to financial market has ma
critics. Critics of behavioral finance concede that systematic errors of judgment i.e. bias do exist. Becau
judgments can be systematically wrong in various ways. But there is a limit to actual impact of this
systematic judgment as people actively search out opportunities to exploit such behavior.

(1) Eugene F. Fama is the most cited critic of behavioral finance, who typically supports the efficient
market theory.

In his writing "Market efficiency, long term returns and behavioral finance" he focused that behavioral
finance is more of a collection of anomalies that are actually just enhance results and support for the
anomalies tend to disappear with changes in the way they are measured.

(2) According to Goedhart, Koller and Wesels, in behavioral finance significant discrepancies between
market value of investment and intrinsic value of investments are rare. They stated mispricing is an
uncommon and temporary phenomenon that occurs only under very special circumstances and when
those circumstances shift "rational investors will step in to drive share prices back to intrinsic value."
(3) Lo in 2005 stated "while all of us are subject to behavioral biases from time to time, traditional
economic theorist argue that market forces will always act to bring prices back to rational levels, implyin
the impact of irrational behavior on financial market is generally negligible and therefore irrelevant".

(4) Curtis pointed out a no. of methodological limitations to behavioral finance studies that use
experimental designs. These are as follows –

(i) Participants of the experiments knew that they were in an experiment and behave accordingly becau
of an unnatural environment of try to please (displease) the researcher.
(ii) They do not always follow the instructions.
(iii) The term "statistically significant" does not necessarily mean that an effect is significant in magnitud
(iv) Experience and education often matter once the investors realize their biases they are likely to chan
and finally the experimenter's expectations of the outcome may impact how participants behave.

CONCLUSION:

The field of modern financial economics assumes that people behave with extreme rationality, but they
not. The two common mistakes investors make i.e. excessive trading and the tendency to
disproportionately hold on to losing investments while selling winners have their origins in human
psychology. Because the tendency for human beings to be over confident causes the first mistake and th
human desire to avoid regret prompts the second. So, psychological research teaches as about the true
form of preferences, allowing us to make finance more realistic within the rational choice framework. Th
is the reason today Behavioral finance is a rapidly growing area that deals with the influence of psycholo
on the behavior of financial practitioners. The above-mentioned arguments are provided for why
movements towards greater psychological realism in finance will improve mainstream finance. Apart fro
these things this particular area also collectively predict some outcomes where the traditional models
failed along with reaches, the same current predictions as the traditional models.

REFERENCES:

1. Curtis's, Gregory. (2004). Modern Portfolio Theory and Behavioral Finance. 16-22.
2. Fama. Eugene F., October 1997. Market efficiency, long term returns and ' behavioral finance'. Jour
of Finance and Economics 49(1998) 283-306.
3. Goedhart, Marc H, Koller, Timothy M. Wessels, David. (2005). What really drives the market? MIT
Sloan Review, 47(1), 21-24.
4. Lo, Andrew W. (2005). Reconciling efficient markets with behavioral Finance: The adaptive markets
hypothesis. The Journal of Investment Consulting, 7(2), 21-44.
5. Sewel Martin, May 2007, Behavioral-Finance.
6. Sharp. William F., Alexander Gordon J., Bailey Jettery V., Sixth Edition 2006, Investments.
7. www.wikipedia.org
8. www.persionsatwork.com/scholarly-work.